To Roth or Not to Roth…
That Is the Question

One of the big questions for investors in 2010 is whether or not to convert their “traditional” IRA to a Roth IRA. This question has become one of the biggest new-business gimmicks for financial institutions to come along in decades.

Several new developments are being touted:

• There is no longer an income limit to convert a traditional IRA or 401(k) into a Roth IRA.

• For 2010 only, you have the option of paying the tax due upon conversion over a two year period (your 2011 and 2012 tax returns).

There are, of course meaningful advantages to a Roth IRA. One of the most important is the tax treatment of contributions and distributions.

• You are not required to take distributions at any time while distribution are required at 70 ½ years of age for a Traditional IRA
• Any monies you withdraw are not subject to either capital gains or income taxes.
• Heirs can withdraw money without paying federal income tax.

What is not being explained in the numerous advertisements for conversion is that conversion to a ROTH IRA can raise a sizable tax bill. In the majority of Traditional IRAs, contributions were made with dollars that were not taxed as income in the year earned.

Therefore, if the tax is paid with monies from inside a Traditional IRA, the funds going into the ROTH by will be reduced by that amount. That means giving up a great deal of the ability to compound the higher Traditional funds in a tax-free account.  Furthermore, conversion may put you into a higher tax bracket for the conversion year.

BOTTOM LINE:  For investors approaching or in retirement, it is most likely not an advantage to convert to a ROTH IRA. There probably will not be adequate opportunity to earn an amount that equals the tax payment due. The ideal situation if you want to convert, therefore, is to pay the tax from funds outside your Traditional IRA. Otherwise, stay put.

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